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Why central bankers would like to trash your cash

That $100 bill in your wallet is so crisp, so new – and now so endangered.

In the wake of the financial crisis, economists have been pondering reforms that might provide a bigger buffer against downturns. Recently, the discussion in some quarters has turned to a radical but intriguing notion: Doing away with paper money.

An end to folding money could offer many advantages, according to Kenneth Rogoff, a Harvard professor and former chief economist at the International Monetary Fund. The most immediate payoffs would come from cracking down on drug traffickers and tax evaders.

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This could have surprisingly large benefits for government coffers. In a column in the Financial Times this week, Prof. Rogoff estimates that untaxed, underground transactions account for 7 to 8 per cent of the U.S. economy and probably even more of its European counterpart. Bringing all those cash-only transactions into the light by forcing them to be conducted through the banking system, where the taxman could track them, would provide governments with a nice revenue boost.

It might also make life more difficult for international criminals. Prof. Rogoff notes that, in February, when police arrested Joaquin "El Chapo" Guzman, the Mexican mobster, they found more than $200-million (U.S.) stacked in a room, presumably to be used in future drug deals. Without large-denomination bills, usually in U.S. dollars or euros, it would be far more difficult to conduct illegal business of such gigantic proportions.

But the biggest benefit of using electronic transactions rather than paper money would come during recessions, when the new system would give policy makers an additional tool to goose the economy.

Right now, central banks reduce interest rates when an economy starts slowing down. Lower rates reduce the incentive for people to keep their money in the bank and makes them more inclined to borrow. Both result in more spending, which stimulates the economy.

The problem occurs when interest rates get close to zero, as they are now. At that point, policy makers' ability to deliver further jolts to the economy dwindles.

One option, in theory, would be to impose negative interest rates – to apply a penalty charge on bank balances to spur people to spend. One big problem with this in practice, however, is that it just won't work because "people will start bailing out into cash," as Prof. Rogoff writes.

But what if there was no cash? Government could then adjust rates however it wanted, even well into negative territory, to force people to stop sitting on their wealth.

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Miles Kimball, a professor of economics at the University of Michigan, has written extensively about how a central bank could "go off the paper standard" and ensure it would always have the ability to stimulate the economy.

The key is having the ability to impose negative interest rates. "People are shocked by negative interest rates, " Prof. Kimball told the Washington Post. "It basically means you're paying a storage company – the bank – to store your money and there are circumstances where that's the way the economy should work."

His basic notion is that a country would use "electronic dollars" (or euros, or yen, depending on the country) as its primary currency. Paper money could still be used but its value would be set in terms of its electronic counterpart.

In a severe recession, like the one that followed the 2008 financial crisis, government could impose negative interest rates on the electronic dollars held in bank accounts. It could also adjust the value of a paper dollar in terms of an electronic dollar to ensure that its effective interest rate was even more negative.

The upshot of these negative interest rates would be an overwhelming motivation to spend money of either type before it lost even more of its purchasing power – and that would kick the economy out of any recession, Prof. Kimball writes.

For the moment, such ideas remain an academic curiosity. But don't count on them remaining so. Prof. Rogoff is already suggesting that, as a first step, governments consider phasing out large-denomination notes.

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About the Author

Ian McGugan is a reporter with The Globe and Mail's Report on Business and has been writing about investing, economics and business for more than 20 years. He joined the Globe and Mail in 2010. He has been executive editor of Canadian Business magazine and founding editor of MoneySense magazine. More


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